Sequence-of-returns risk: why the order of returns matters

A long-term average return describes the destination, not the road. For an investor who is not withdrawing money, the order of annual returns barely matters: the same set of returns in any order compounds to the same result.

Once monthly withdrawals begin, the order matters a great deal. Selling in a falling market converts a temporary decline into a permanent reduction of the invested base.

Consider two portfolios with identical average returns but reversed sequences. The one that suffers its losses first has fewer units left to participate in the later recovery, because units were sold each month to fund the payment.

• ·Losses early: withdrawals consume a larger share of a shrunken portfolio
• ·Losses late: the early gains have already grown the base that funds withdrawals
• ·Same arithmetic average, materially different capital remaining

A fixed €1,000 monthly payment is a rising percentage of a falling portfolio. At €240,000 it is 0.42% of capital per month. If the portfolio halves, the same payment is 0.83% per month. Nothing about the plan changed, but the withdrawal became twice as demanding.

• ·Size the monthly payment conservatively relative to capital
• ·Prefer a longer horizon and a lower payout over the reverse
• ·Understand that remaining capital is variable, not contractual
• ·Accept broader diversification when the range of outcomes matters more than the peak outcome
• ·Review the plan periodically rather than assuming a fixed payment is permanently sustainable

None of these responses eliminates the risk. They change how much of it is carried.

See how withdrawals, fees and returns interact on the monthly income plan page, or compare the two portfolio approaches in Broad Market or Market Leaders.